Regular Income VS Capital gain

An investment usually produces a combination of a regular income and a capital gain. Different types of investment produce different combinations of these two types of return to the investor. Some investments produce only a regular income without any capital gain; for example, fixed deposit. While at the other extreme, some investments produce no regular income but promise the possibility of high capital gain; for example, investment in gold or diamonds.

The implications of these two types of return will be discussed in more detail in a later chapter For the moment, the two important characteristics of these two types of return will be pointed out. First, an investment which relies on capital gain to reward its investor usually (but not always) produces much higher return than one which relies on regular income. Again, this goes back to the law of supply and demand. An investment which relies on capital gains alone to reward its investors is less attractive than one which provides the investors with regular income because the former is much less certain than the latter. Furthermore it is only received right at the end of the period of investment. One only has to look at the way the price of gold had plunged from US$850 an ounce to US$300 an ounce to realize how true this statement is.

Second, an investment which relies on capital gain alone is a much more risky investment than one which provides a regular income. Let us start by looking at the difference in riskiness between investment in bonds or gold. Let us consider the case of an investor who needs a regular income from her investment (say, a Widow). In the case of gold, there is no regular income and she has to rely on the ability of selling off some gold at an advantageous price in order to get a return on her capital. What if the price of gold plunges? She would be forced to sell more of her gold than she would like to. But in the case of bonds, even though its market price may fluctuate, she gets a constant annual return irrespective of the market price. For the widow and similar investors, the bond is certainly a much more preferable investment. Is it surprising therefore that the long term average return on bonds is much lower than that of gold?

We can now examine the same principle as applied to share investment compared with putting money in long term fixed deposits. Over the long run, the return on an investment of shares is very much higher than the return on fixed deposits. Historically in Malaysia/Singapore, the return on share investment had been about twice as high than that obtainable on fixed deposit (based on past ten years’ record). However, since one can never get something for nothing, the much higher return has been accompanied by much greater riskiness of an investment in shares because much of the return from share investment has been in the form of capital gain which is highly unpredictable. Historically, about three quarters of the total return obtainable from share investment has been in the form of capital gain. The high return on share investment had been obtained by a combination of good years when the return may be higher than 100 per, cent as well as had years when the loss may exceed 50 per cent. The changes in the price of share have been so large that they totally swamp the small regular dividend income one can get from shares (in the region of 2-4 per cent on the value of the initial investment).

After examining these three characteristics of investment, we are now in a position to answer the question posed earlier as to why should some people prefer to keep their money in savings accounts rather than investing in shares. The answer is that some people are subconsciously (or consciously) aware of the basic principle of investment that is so much liked by Professor Milton Friedman and other economists:

“THERE IS NO SUCH THING AS A FREE LUNCH”

Share investment brings with it many risks, many people are just too conservative to want to invest in shares. Whilst it is true that historically, shares had produced very high return for some investors, such investments are not without some drawbacks. In exchange for such high return, investors in shares have to pay a high price in terms of Peace of mind and sound sleep at night. Shares can be a very illiquid asset; it is also very uncertain in terms of the return that can be obtained; and a high proportion of the return on share investment is in the form of Capital gain which is only obtainable when the share is sold some time In the very uncertain future.